Money goes where it’s treated the best.

And the US stock market has been extremely kind to money over the last 100 years.

Thus, the path of least resistance for stocks is for them to go higher over the long term.

However, there is a subset of stocks that I think treats money particularly well.

Those are high-quality dividend growth stocks.

It takes a special kind of stock to reliably pay out dividends for decades.

That’s because it takes a special kind of business to produce the necessary profit for decades.

High-quality dividend growth stocks take it to the next level, as they’ve been paying increasing dividends for decades.

You can see what I mean by checking out the Dividend Champions, Contenders, and Challengers list.

Investing in high-quality dividend growth stocks for myself allowed me to retire in my early 30s.

And I lay out in my Early Retirement Blueprint exactly accomplish that.

Suffice it to say, a lot of saving and investing was involved.

By putting my hard-earned savings to work with high-quality dividend growth stocks, I built my FIRE Fund.

That’s my real-money dividend growth stock portfolio, which produces, the five-figure dividend income I live off of.

Jason Fieber's Dividend Growth PortfolioBut I didn’t just invest in any dividend growth stocks.

I invested in the highest-quality dividend growth stocks at the best possible valuations.

Price is what you pay. But it’s value that you get for your money.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk. 

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value. And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Buying the highest-quality dividend growth stocks at the lowest possible valuations almost guarantees you life-changing wealth and passive income over the long term.

And the good news is that finding those stocks isn’t all that difficult.

The valuation part of the equation has been made a lot easier with Lesson 11: Valuation.

Penned by my colleague Dave Van Knapp, it lays out a valuation template that you can apply to almost any dividend growth stock out there.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Gilead Sciences, Inc. (GILD)

Gilead Sciences, Inc. (GILD) is a biopharmaceutical company that develops and markets therapies to treat a variety of life-threatening diseases.

Founded in 1987, Gilead is now a $84 billion (by market cap) global drug giant that employs more than 13,000 people.

The company’s three primary disease areas are viral diseases, inflammatory diseases, and oncology.

Gilead specifically focuses on HIV and hepatitis B and C.

Their HIV franchise accounted for approximately 70% of FY 2020 sales. Biktarvy, which treats HIV, is their most important drug, making up about 29% of total FY 2020 sales.

The US accounted for approximately 74% of FY 2020 sales.

The rationale for investing in a major biopharmaceutical company such as Gilead is always straightforward.

Simply put, healthcare is a non-discretionary expense that has constant demand. If someone can afford top-flight healthcare, they will do whatever they can to access it.

With the world growing bigger, older, and wealthier, demand for and access to high-quality healthcare products such as life-saving drugs is only going to rise.

That bodes well for a company like Gilead to continue growing its profit and dividends over the long run.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it sits, Gilead has already increased its dividend for seven consecutive years.

With a three-year dividend growth rate of 9.4% coming on top of the stock’s current yield of 4.22%, there’s an appealing combination of yield and growth here.

That market-beating yield, by the way, is more than 70 basis points higher than the stock’s own five-year average yield.

And the dividend is protected by a low payout ratio of 37.9% (based on TTM adjusted EPS).

The dividend metrics are surprisingly strong for Gilead.

You want a high yield, fairly high dividend growth rate, and low payout ratio? Check, check, and check.

The only knock against them is that more recent dividend raises have been smaller.

Dividend growth has definitely decelerated, with the most recent dividend increase coming in at less than 5%.

Revenue and Earnings Growth

As strong as these dividend metrics are, though, they’re looking at what’s already transpired.

But today’s investors are risking their capital for tomorrow’s results.

As such, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to estimate the stock’s intrinsic value.

I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near-term professional prognostication for profit growth.

Blending the proven past with a future forecast in this way should allow us to sensibly extrapolate out a growth path for them.

Gilead grew its revenue from $8.385 billion in FY 2011 to $24.689 billion in FY 2020.

That’s a compound annual growth rate of 12.75%.

While this is impressive, it’s important to keep in mind that revenue peaked in FY 2015 at over $32 billion for that year. Gilead is, in some ways, a victim of its own success – their revolutionary HCV cure eliminated the need for treatments.

Nonetheless, the long-term picture is still excellent.

Earnings per share increased from $1.77 to $7.09 (adjusted) over this period, which is a CAGR of 16.67%.

Again, we have an outstanding 10-year result that has to be viewed within the context of mid-decade explosive growth that has recently cooled down rather significantly.

Share buybacks drove a lot of excess bottom-line growth. The outstanding share count is down by 20% over the last decade.

Looking forward, CFRA is projecting that Gilead will compound its EPS at an annual rate of 6% over the next three years.

This might seem disappointing in light of what the company has historically been able to do, but I think it’s a reasonable estimation of the near-term growth potential when you factor in more recent results.

A bet on Gilead is largely a bet on their HIV franchise, which is the linchpin of the business.

CFRA sees considerable growth ahead for their key HIV Biktarvy drug, offset by the loss of exclusivity in other HIV drugs such as Atripla and Truvada.

The company’s pipeline is healthy. It includes a total of 82 different compounds.

In addition, the $21 billion acquisition of Immunomedics could pay off handsomely. Key cancer drug Trodelvy received FDA approval in April 2020. This drug is expected to do $3.5 billion in annual sales by 2026.

Gilead is also seeing a temporary boost from sales of COVID-19 treatment Veklury (branded Remdesivir).

A near-term 6% EPS growth rate is likely to lead to a similar or better near-term dividend growth rate, especially after factoring in the low payout ratio. And that’s appealing when you pair that kind of growth with a starting yield of over 4%.

Financial Position

Moving over to the balance sheet, they have a good financial position.

There has been some deterioration of the balance sheet in recent years, as Gilead has sought out growth through acquisitions. But their position is not weak.

The long-term debt/equity ratio of 1.72 looks high, but I see that as a function of low common equity rather than a high debt load.

The interest coverage ratio is N/A for FY 2020 due to unusually volatile GAAP earnings; however, we can see that the interest coverage ratio for FY 2019 was over 6, indicating no issues with debt servicing. Their interest expense has not materially increased YOY.

Robust profitability is a bright spot for the business.

Over the last five years, the firm has averaged annual net margin of 23.06% and annual return on equity of 33.09%.

Fundamentally, Gilead is sound, bordering on outstanding, across the board.

However, a reduction in demand for HCV treatment vis-a-vis their development of a cure, combined with very high expectations for the stock five years ago, have created the conditions for poor stock performance over the last few years.

But with expectations now low and revenue back on the upswing, there could be a long-term opportunity here.

And the company does benefit from durable competitive advantages that include economies of scale, IP, patents, R&D, inelastic demand for products, and an established relationship with partners.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

The slowing HCV market and incoming generics for HIV threaten Gilead’s sales base.

There’s integration risk with Immunomedics, as well as pressure on Trodelvy to perform.

And there’s always the risk that the pipeline doesn’t produce enough new blockbusters in order to overcome slowing sales from older drugs.

Overall, I view these risks as manageable.

That’s particularly true when they’re lined up against the valuation, which is compelling…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 8.97, based on adjusted TTM EPS.

That’s a very low earnings multiple by any standard, even for a business that has suffered some disappointments in recent years.

However, using adjusted EPS does cloud things.

On the other hand, the stock’s P/S ratio of 3.3 is markedly below its own five-year average of 3.8.

And the yield, as noted earlier, is substantially higher than its own recent historical average.

So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?

I valued shares using a dividend discount model analysis.

I factored in a 9% discount rate (to account for the high yield) and a long-term dividend growth rate of 5%.

I’m modeling in low expectations. It’s not a high bar for the business to clear.

This DGR is lower than both the demonstrated long-term EPS growth rate and dividend growth rate. I’m also coming in below CFRA’s near-term EPS growth forecast.

With a low payout ratio and higher near-term EPS growth expected to materialize, I think this is a rational, if slightly cautious, calculation.

The DDM analysis gives me a fair value of $74.55.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

Even after what I’d argue was a cautious analysis, the stock looks cheap.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates GILD as a 4-star stock, with a fair value estimate of $81.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates GILD as a 3-star “HOLD”, with a 12-month target price of $66.00.

I came out right in the middle this time. Averaging the three numbers out gives us a final valuation of $73.85, which would indicate the stock is possibly 10% undervalued.

Bottom line: Gilead Sciences, Inc. (GILD) is a high-quality biopharmaceutical firm benefiting from the demographic tide lifting all boats. Growth is back on the upswing and expectations are low. With a market-beating 4%+ yield, inflation-beating dividend growth, a low payout ratio, and the potential that shares are 10% undervalued, this is an attractive long-term idea in an otherwise expensive stock market.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

Note from DTA: How safe is GILD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, GILD’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

This article first appeared on Dividends & Income

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